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Stochastic Optimization and Worst-Case Analysis in Monetary Policy Design

  • Stan Žaković
  • Volker Wieland

    ()

  • Berc Rustem

In this paper, we show how stochastic optimisation and worst-case analysis can be used together in order to provide central banks with a straightforward tool for selecting a policy rule that limits worst-case outcomes while at the same time providing reasonably good performance on average. We conduct this analysis within a simple estimated model of the euro area with adaptive expectations. In particular, we consider not only uncertainty due to additive shocks but also uncertainty with respect to all the parameters of the model, including multiplicative parameters and potential nonlinearities in the inflation-output relationship. In terms of monetary policy we focus on the optimal choice of response coefficients in a Taylor-style interest rate rule that responds to inflation and the output gap and we evaluate the performance of this type of rule by means of a standard quadratic loss function in output and inflation. We then compare the rules obtained by the two different methods by comparing their respective performance in the worst-case scenario as well as the overall expected performance given the empirical probability distributions.

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File URL: http://hdl.handle.net/10.1007/s10614-005-9012-4
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Article provided by Society for Computational Economics in its journal Computational Economics.

Volume (Year): 30 (2007)
Issue (Month): 4 (November)
Pages: 329-347

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Handle: RePEc:kap:compec:v:30:y:2007:i:4:p:329-347
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  1. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series 1998-45, Board of Governors of the Federal Reserve System (U.S.).
  2. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
  3. J. Tetlow, Robert & von zur Muehlen, Peter, 2001. "Robust monetary policy with misspecified models: Does model uncertainty always call for attenuated policy?," Journal of Economic Dynamics and Control, Elsevier, vol. 25(6-7), pages 911-949, June.
  4. Karakitsos, E. & Rustem, B., 1984. "Optimally derived fixed rules and indicators," Journal of Economic Dynamics and Control, Elsevier, vol. 8(1), pages 33-64, October.
  5. Onatski, Alexei & Stock, James H., 2002. "Robust Monetary Policy Under Model Uncertainty In A Small Model Of The U.S. Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 85-110, February.
  6. Ann-Charlotte Eliasson & Peter Isard & Douglas Laxton, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," IMF Working Papers 99/75, International Monetary Fund.
  7. Orphanides, Athanasios & Wieland, Volker, 2000. "Inflation zone targeting," European Economic Review, Elsevier, vol. 44(7), pages 1351-1387, June.
  8. Giannoni, Marc P., 2002. "Does Model Uncertainty Justify Caution? Robust Optimal Monetary Policy In A Forward-Looking Model," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 111-144, February.
  9. repec:cup:macdyn:v:6:y:2002:i:1:p:111-44 is not listed on IDEAS
  10. Levin, Andrew & Wieland, Volker & Williams, John C., 2003. "The performance of forecast-based monetary policy rules under model uncertainty," CFS Working Paper Series 2003/06, Center for Financial Studies (CFS).
  11. Rustem, Berc, 1994. "Stochastic and robust control of nonlinear economic systems," European Journal of Operational Research, Elsevier, vol. 73(2), pages 304-318, March.
  12. Christopher A. Sims, 2001. "Pitfalls of a Minimax Approach to Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 51-54, May.
  13. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  14. Athanasios Orphanides, 1998. "Monetary policy evaluation with noisy information," Finance and Economics Discussion Series 1998-50, Board of Governors of the Federal Reserve System (U.S.).
  15. Lars Hansen & Thomas Sargent & Thomas Tallarini, . "Robust Permanent Income and Pricing," GSIA Working Papers 1997-51, Carnegie Mellon University, Tepper School of Business.
  16. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters, in: Monetary Policy Rules, pages 127-156 National Bureau of Economic Research, Inc.
  17. Peter von zur Muehlen, 2001. "Activist vs. non-activist monetary policy: optimal rules under extreme uncertainty," Finance and Economics Discussion Series 2001-02, Board of Governors of the Federal Reserve System (U.S.).
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